The role of psychology in investment decisions, economic behaviour

The tenets of behavioural economics suggest that intuitive appeal of whether to invest is a social process that seems to rely much on the laws of psychology.

Updated: Aug 08, 2012, 05.21 AM IST

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Finance minister P Chidambaram seems keen to improve investor confidence, in the backdrop of the markedly decelerating economic growth trend. In his first press conference, he opined that interest rates were on the higher side, promised to keep tab on food inflation for added measure and called for review of the provisions in the latest Finance Act concerning retrospective corporate taxation on certain cross-border transactions and sectors. The strategy outlined, as and when implemented, should be growth-inducing.

However, there is now a considerable body of knowledge that holds that investor resolve and attendant investment are more often than not driven by intuition rather than analytical reasoning. It follows that while easier cost of funds, less controversial tax initiatives and reduced government expenditure frittered away in open-ended consumption subsidies on fuel, say, would all tend to improve investor confidence levels, they may fall short of having the required psychological effect overall to purposefully boost the investment rate.

It is a fact that there's been considerable slowdown lately in the domestic investment rate, particularly of the corporate variety. And to rev up capital budgeting and optimise investment levels economywide, what is generally suggested are elaborate methods to measure the relative attractiveness of various alternative projects. There is the usual recourse to workout-projected cash-flows from the investments planned, the estimated cost of capital across the project period can be arrived at as well, and the mavens often gauge other related risks. For example, it pays to number-crunch and extrapolate how the proposed investment activity would affect stock prices. And such correlations and risk analysis can lead to probing multiple factors and carrying out other modelling exercises.

For instance, it can be worthwhile doing scenario analysis to find out how the commitment decision (read: investment planned) would provide opportunities for learning by doing and project implementation, result in new possibilities for marketing, distribution channels and sales, and generally bring about synergy with other investments and projects.

There is no standard recipe to quantify all such factors elaborated in the theory of capital budgeting. In any case, those in business operate in highly-competitive environments and the investment decisions need to be taken quickly, objectively and with the available information. Or, so goes the standard theory on corporate finance.

In recent decades though, it has increasingly come to be accepted that psychological factors play a major role in investment decisions and economic behaviour, broadly speaking. Often enough, when the intuition for investment is not quite there, the commitment decision is generally delayed or kept in abeyance.

The tenets of behavioural economics suggest that intuitive appeal of whether to invest on the part of investors is a social process that seems to rely much on the laws of psychology. As per the new thinking, group decisions do matter and, hence, social psychology is of particular import for key decisions such as investment and expansion.

The point is that business investors make decisions in the backdrop of fundamental uncertainty about the future, and in so doing, they seem to take psychological gut reaction on the viability or otherwise of the proposed investment into account. The phase 'mental accounting' denotes such mind activity that is really 'straight from the gut' feel about payback and returns. It follows that in a scenario of much overextended government finances, rising inflationary expectations, besides political uncertainty in the medium term, the sheer lack - for long - of policy reform to boost investment across industries and rationalise taxes would be psychologically off-putting and affect investor sentiment. The weak external environment does not help either. Key members of the government keep stressing that the fundamentals of the India growth story remain unchanged. But it cannot be gainsaid that sentiments have changed for the worse and, in such a scenario, the Centre needs to be far more proactive and reform-oriented to make a real impact on the policy front.

That said, mental accounting can well lead to grossly irrational decision-making. For example, it can mean imposing severe cost caps on core businesses, while spending freely on a start-up. Those into betting who lose their winnings typically don't feel that they have lost anything.

All investments need to be judged on a consistent criterion. Or, consider the sunk-cost bias, also known as 'throwing good money after bad'. Once the brain has been fixated on investing in a large uneconomic project, continuing to spend extra sums on it seems not so bad. It also makes sense to avoid herding behaviour or false consensus or the 'confirmation bias', the tendency to seek out opinion and facts that support one's pet thesis, hypotheses and beliefs.

There is no standard recipe to quantify all such factors elaborated in the theory of capital budgeting. In any case, those in business operate in highly-competitive environments and the investment decisions need to be taken quickly, objectively and with the available information. Or, so goes the standard theory on corporate finance.

In recent decades though, it has increasingly come to be accepted that psychological factors play a major role in investment decisions and economic behaviour, broadly speaking. Often enough, when the intuition for investment is not quite there, the commitment decision is generally delayed or kept in abeyance.

The tenets of behavioural economics suggest that intuitive appeal of whether to invest on the part of investors is a social process that seems to rely much on the laws of psychology. As per the new thinking, group decisions do matter and, hence, social psychology is of particular import for key decisions such as investment and expansion.

The point is that business investors make decisions in the backdrop of fundamental uncertainty about the future, and in so doing, they seem to take psychological gut reaction on the viability or otherwise of the proposed investment into account. The phase 'mental accounting' denotes such mind activity that is really 'straight from the gut' feel about payback and returns.

It follows that in a scenario of much overextended government finances, rising inflationary expectations, besides political uncertainty in the medium term, the sheer lack - for long - of policy reform to boost investment across industries and rationalise taxes would be psychologically off-putting and affect investor sentiment. The weak external environment does not help either. Key members of the government keep stressing that the fundamentals of the India growth story remain unchanged. But it cannot be gainsaid that sentiments have changed for the worse and, in such a scenario, the Centre needs to be far more proactive and reform-oriented to make a real impact on the policy front.

That said, mental accounting can well lead to grossly irrational decision-making. For example, it can mean imposing severe cost caps on core businesses, while spending freely on a start-up. Those into betting who lose their winnings typically don't feel that they have lost anything.

All investments need to be judged on a consistent criterion. Or, consider the sunk-cost bias, also known as 'throwing good money after bad'. Once the brain has been fixated on investing in a large uneconomic project, continuing to spend extra sums on it seems not so bad. It also makes sense to avoid herding behaviour or false consensus or the 'confirmation bias', the tendency to seek out opinion and facts that support one's pet thesis, hypotheses and beliefs.